Emerging markets now a stock-pickers market?

The recent economic slowdown in China and Brazil is prompting some investors to take a decidedly old-school approach when it comes to emerging markets: stock-picking.

Though buying and selling individual companies based on their merits is as old as Wall Street itself, it’s a practice that had fallen out of favor recently.

The rapid growth in emerging markets like China, Brazil and India over the past few years led many to pass over active management on the theory that a rising tide would lift boats throughout the developing world.

Dollars flowed instead to passively managed index funds and exchange traded funds such as the $50.6 billion Vanguard MSCI Emerging Markets ETF, which now is one of the largest funds in the world by assets under management.

But popularity comes with its downsides. Some advisers and money managers contend that passively managed emerging markets funds are too top-weighted toward exporters and other cyclical industries whose revenues may be tied to economic growth in the U.S. or Europe. These managers are instead turning to active management, or stock-picking, to target the global emerging middle class.

“What we want to invest in is in Indians who can buy an extra bottle of shampoo or extra shirts. I don’t want to invest in another call center for Europe because the consumption of the developed world is very sluggish,” said Weyman Gong, a principal at Signature, a Norfolk, Virginia based wealth management firm with about $2 billion in assets under management.

Emerging market index funds tend to be too tied toward industries like energy or mining rather than smaller companies that focus on providing such basics of middle class life as cell phone service, food and entertainment, Gong said.

The iShares MSCI Brazil index, for instance, has about 35 percent of its portfolio invested in the energy and materials sectors, according to Morningstar. The Market Vectors Russia ETF, meanwhile, has 40 percent of its portfolio invested in energy companies. Vanguard’s large MSCI Emerging Markets fund has about 35 percent of its portfolio invested in materials, financials or energy companies.

“We try not to use ETFs in emerging markets, with Russia being the extreme example. You’re not investing in Russia with these funds, you’re investing in global oil,” he said.

Gong favors actively managed funds like the $1.6 billion Harding Loevner Emerging Markets Advisor fund, which has overweight stakes in technology, healthcare and defensive stocks. The fund, whose top holdings include Samsung Electronics, Wal-Mart de Mexico, and Baidu, is up 5.8 percent for the year.

Mutual fund managers say that their ability to deviate from a benchmark index gives them an advantage.

“Stock-picking is valuable now because you are seeing some companies do a lot better than their economies. When you see investors selling everything (because of economic reports), it presents opportunities,” said Larry Seruma, the portfolio manager of the $14.3 million Nile Pan Africa Fund.

He’s targeting consumers in Egypt, South Africa, Kenya and other developing nations in Africa through companies like East African Breweries, which brews and distributes brands like Bell beer and Smirnoff vodka in East Africa, and Tiger Brands Limited, which sells packaged foods like Black Cat Peanut Butter.

Seruma points to stock-picking as one reason for his strong performance this year. The fund is up 25.2 percent for the year, according to data from Lipper, compared with a 4.4 gain for the iShares MSCI Emerging Markets fund, a cap-weighted ETF.

“The big problem with ETFs is that they are always flat-footed because they have fixed weights,” he said.

The top ten performing actively managed emerging markets funds have gained an average of 12.1 percent since the start of the year, according to Morningstar. The best passive index and ETF funds, meanwhile, have returned an average of 11.4 percent, a return boosted by gains of 30 percent each for ETFs that target Egypt and Turkey, exclusively. Take out those outliers, and the average gain shrinks to 6.9 percent.

Richard Gao, portfolio manager of the $5.9 billion Matthews Pacific Tiger Fund, said that the Asian stock markets were in the midst of a transition that’s not reflected in the broad indices.

“Asia’s growth going forward will be more and more driven by the domestic economy rather than relying on export growth or infrastructure growth like they did in the past,” he said.

As a result, he’s focusing on consumers through companies like Malaysia-based Genting, a conglomerate whose businesses span from casinos to power generation, and Ping An Insurance Group, a Chinese insurance and financial services company which employs nearly half a million life insurance agents.

Derrick Irwin, a portfolio manager with the $2.7 billion Wells Fargo Advantage Emerging Markets Equity Fund, said that he expects concerns about slowing growth rates in China and India to lead to volatile markets through the rest of the year.

“Right now it’s a tough environment to be picking stocks, but we think it’s the right thing to be doing,” he said.

He’s been buying consumer companies in China, India and Brazil like Brazilian retailer Lojas Americanas S.A. that have strong brand names or other competitive advantages. One pick, Tingyi, sells packaged noodles and does much of the bottling for PepsiCo in China.

“This is a way to piggyback on Pepsi’s world-class branding efforts using Tingyi’s excellent distribution network,” he said.